Sunday, October 15, 2006

Prop 87 is not Pigovian

Prop. 87 aims to raise $4 billion by placing a new tax on oil production, in addition to taxes oil companies already pay. The money would be used to finance research and development of alternative fuels; education campaigns; and subsidies to consumers who buy vehicles that use alternative fuels and businesses that produce and distribute alternative fuels.

The goal of Pigovian taxes is to ensure that market prices reflect social costs. Once private and public interests are aligned, people are then free to make their own decisions over the allocation of resources, and they will have the right incentives to reach an efficient outcome.

By contrast, this measure seems more like government central planning. Indeed, the spending side of the proposition is exactly that. But what about the tax itself? Advocates claim that the tax would not be passed on to consumers. Given that oil prices are set in a world market, this claim seems about right to me. Most of the tax would likely be paid by local oil producers rather than oil consumers. Although this lack of pass-through to consumers may make the tax more attractive politically, it means that there would be no incentive working through the price system for people to cut back on oil consumption.

From a Pigovian perspective, the tax proposed by Prop 87 makes sense only if there are negative externalities from oil production in California. If we want Californians to produce less oil and import more from Saudi Arabia and Venezuela, then the proposed tax is well designed. But this goal does not seem the right one to me. I see negative externalities flowing from oil consumption rather than domestic oil production.

I doubt, therefore, that a majority of the Pigou Club would support the measure. But I am only one member. If the Club ever has a meeting, I will make sure to put the question on the agenda.

About Me

I am the Robert M. Beren Professor of Economics at Harvard University, where I teach introductory economics (ec 10). I use this blog to keep in touch with my current and former students. Teachers and students at other schools, as well as others interested in economic issues, are welcome to use this resource.